In this introductory guide, we will explore some fundamental components that form the foundation of futures trading. In earlier chapters, it is noted that futures derive their value based on underlying assets (commodities or financial instruments).  There are some other components that beginners should know about before attempting futures trading.

Margin:

There is also margin involved in futures trading, traders are required to deposit a certain percentage (usually 5%-10%) of the value of the futures contract as margin, which serves as financial collateral to fulfill the obligations of the futures contract. Only after depositing the margin can traders participate in buying and selling futures contracts, and they may be required to add additional funds based on price fluctuations. This system, known as the margin system, not only reflects the unique "leverage effect" in futures trading but also serves as an important risk control mechanism for exchanges

Daily Settlement:

The daily settlement system, also referred to as "mark-to-market" or "daily clearing," is a vital mechanism implemented by exchanges to facilitate smooth and transparent settlements in the realm of futures trading. At the end of each trading day, this system reconciles the positions held by traders by using the daily settlement price as the reference point. Within this system, profits obtained from successful trades are credited to traders' margin accounts, bolstering their capital.

Conversely, any losses incurred are debited from the margin accounts. It is crucial for traders to maintain sufficient funds in their margin accounts, ensuring they meet the required margin levels. Failure to replenish funds promptly may result in a perceived margin deficiency. To safeguard market integrity and prevent defaults, exchanges and brokerage firms are empowered to take proactive measures, such as forced liquidation, if a trader fails to meet their financial obligations. By maintaining a robust daily settlement system, exchanges aim to promote fairness, risk management, and accountability within the futures trading ecosystem.

Physical Delivery:

It refers to the exchange's regulations that require the exchange of ownership of the underlying commodity specified in the futures contract upon its expiration, thereby closing out any open contracts.

Forced Liquidation:

The forced liquidation system is implemented by exchanges to prevent further risks when a client’s trading margin is insufficient and not replenished within the specified time, or when the client’s position exceeds the predetermined limit or violates the rules. In such cases, the exchange enforces forced liquidation, which involves closing out relevant positions held by the client as a mandatory measure.

Price Limit:

Price limits, commonly referred to as daily price fluctuation limits or trading limits, are established measures implemented by exchanges to govern the maximum allowable range of price fluctuations for a futures contract within a single trading day. These limits serve as safeguards against excessive volatility and potential market manipulation. When quotes or trades surpass these predefined limits, they are deemed invalid and unable to be executed.

It is important for traders to familiarize themselves with the specific price limit rules and ranges set by the exchange governing their chosen futures contract, as these provisions play a crucial role in maintaining market stability and fair trading practices.

Position Limit:

Position limits are an essential part of futures trading to prevent market manipulation and excessive risk concentration. These limits restrict the number of contracts an investor can hold, helping to maintain a fair and orderly market. If the limits are exceeded, exchanges may enforce measures such as forced liquidation or increased margin requirements to ensure compliance and protect market integrity. Position limits play a crucial role in promoting transparency, reducing risks, and fostering a balanced trading environment.

Large Trader Reporting:

The large trader reporting system is an integral component in futures trading, designed to enhance market transparency and manage risks associated with significant market participants. Under this system, traders are required to report their financial and position details to the exchange when their speculative positions in a specific commodity contract reach or exceed 80% (including nominal value) of the exchange's designated position limit. This system works in tandem with the position limit system to prevent market manipulation by large traders and effectively control potential market risks. By promoting reporting obligations, this system fosters a fair and well-regulated trading environment while ensuring market integrity and stability.

The Risk Reserve Fund System:

The risk reserve fund system is implemented by exchanges to safeguard their ability to meet contractual obligations. Under this system, exchanges set aside a portion of customer transaction fees as a reserve fund. This fund serves as a financial cushion, ensuring the exchange's capacity to fulfill its obligations in futures trading. By maintaining an adequate reserve, exchanges enhance their ability to handle unforeseen events and uphold market integrity. This system plays a vital role in promoting confidence and stability within the futures market ecosystem.